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It’s Time To Talk About Petrodollar Flows

Oil prices are up – maybe you noticed. As Donald Trump would say, “that number is raising, rising“…

And speaking of Trump and oil prices that are “raising, rising”, he’s not thrilled with recent price action, something he made clear late last week when he put on his commodities strategist hat and told the world that crude prices shouldn’t be as high as they are because there’s “oil all over the place, including the fully loaded ships at sea.”

Although crude briefly dipped on Monday when the Treasury suggested sanctions on Rusal could be lifted, it quickly recovered amid reports that the Saudi-Houthi conflict has escalated further and the bottom line is this:

That, even as the dollar is staging a notable rally.

Clearly, there are all kinds of implications here, including the read-through for inflation expectations, but let’s zoom in on petrodollar recycling.

If you think back to August 2015, one of the worries was that between the Saudis running down their SAMA reserves amid declining oil prices and the Chinese liquidating their FX reserves to try and control the pace of the yuan devaluation, the world was about to get a preview of “quantitative tightening.” Remember, “QT” was a buzzword long before people started talking about the effect of Fed balance sheet rundown and the ECB taper.

There are renewed questions about China’s long-term commitment to buying USD assets, but with crude prices “raising, rising” anew, it’s worth asking whether the recycling of oil revenue could effectively offset some of the negative flow impulse from Fed balance sheet runoff and, ultimately, the ECB taper (with the latter raising questions about reserve diversification and the euro).

This is something JPMorgan’s Nikolaos Panigirtzoglou took up in his latest Flows & Liquidity piece. He begins by noting the magnitude of the sea change(s):

The increase in oil prices is generating a shift in flows and incomes across the world, effectively reversing the previous big shift seen between 2014 and 2016. Oil consumers had spent $3.4tr in 2014 on crude and related products with an average oil price of $100 per barrel, and in 2016 they had spent less than half of that, i.e. $1.6tr with an average oil price of $45 per barrel during 2016. In other words there was a massive $1.8tr or 2.2% of global GDP income transfer between oil consumers and oil producers between 2014 and 2016. These income transfers have been partially reversing over the past two years as the average oil price rose to $55 during 2017 and to $74 currently in 2018. If we assume an average oil price of $74 for 2018, close to the current level, it would mean that more than half of the previous 2014/2016 income transfer would have been reversed in two years i.e. during 2017 and 2018, with most of this reversal taking place this year. What does this income transfer reversal mean for bond and equity flows?

Good question. As Panigirtzoglou goes on to note, oil exporters raked in some $1.6 trillion from crude in 2014, a figure that dropped precipitously to < $800 billion in 2016. Here’s how that translated into “QT”:

In 2014, around 84% or $1.4tr of the $1.6tr oil revenue was recycled via imports and the remaining 16% or $260bn was recycled via SWFs and FX reserves, mostly SWFs. In 2016, 118% or $930bn of the $800bn of oil exporters’ revenues was recycled via imports of goods and services from the rest of the world, $140bn of which was funded by SWF and FX reserve decumulation.

If you do the math there, that means that in the space of just two years, there was a ~$400 billion decline in reserve accumulation from oil exporters. That’s “QT” – depending of course on what they’re accumulating. Speaking of that, here’s the breakdown as detailed by JPMorgan:

Bond purchases via the SWF and FX reserve managers’ vehicles of oil exporters were estimated to have declined by $80bn between 2014 and 2016, while public equity purchases had declined by $160bn (Figure 5).

So as you can see there, assuming $74/bbl in 2018, the flows reverse as exporters begin to recycle their higher revenue via financial assets.

Of course there are two sides of this. What was lost to oil exporters was gained by consumers and on JPM’s estimates, “the oil income windfall to oil consuming industries had likely created a bullish flow into fixed income during 2015 and 2016, bigger in size than the fixed income flows resulting from the decumulation of SWF/FX reserves of oil exporting countries during these two years.”

Interestingly, the bank says the reversal of the savings impulse from lower oil prices among consumers will actually mean that the flow for bonds from higher oil prices is a net negative this year – that is, the hit to consumers and the assumed reduction in their capacity to save via fixed income will outweigh the reverse of petrodollar recycling into DM bonds by oil exporters.

On the bright side, a sustained rally in crude could lead to a materially positive flow into equities both from SWFs and from company buybacks, but JPM does caution that it’s “of secondary importance” (and by that they mean what ultimately matters is whether institutional and retail investors are willing to be the marginal equity buyer).

Finally, it’s worth asking where any recycled flows will go – that is, will this be an excuse to diversify away from USD assets and into EUR-denominated assets, thus perpetuating the “reserve diversification” meme? Who knows.

Writing about a subject is the best
way to educate yourself about it, and when I flick through past work I remember how much
they taught me, if no one else. Mainly they taught me that I didn’t know very much. But they
also taught me that most other people didn’t know much either. Thus, some key themes
which stand out include the illusory control of policy makers, the presumed knowledge of
those looking to them to actively do good, the ease with which we fool ourselves, and how
best to protect capital in the face of such unavoidable uncertainty. -- Dylan Grice